Sunday, June 30, 2013

Since 2008, I have seen various analysts criticizing the Fed, ECB and other central banks for their efforts at quantitative easing and other forms of unconventional monetary policy. These policies have been criticized as less than effective. One such analyst is Stephen Roach, formerly of Morgan Stanley:

While the Fed’s first round of quantitative easing helped to end the financial-market turmoil that occurred in the depths of the recent crisis, two subsequent rounds – including the current, open-ended QE3 – have done little to alleviate the lingering pressure on over-extended American consumers. Indeed, household-sector debt is still in excess of 110% of disposable personal income and the personal saving rate remains below 3%, averages that compare unfavorably with the 75% and 7.9% norms that prevailed, respectively, in the final three decades of the twentieth century.

Now that the Fed is hinting that it is thinking of taking its foot off the accelerator, we are now seeing the reversal of some of the effects of QE - and it's sent the markets into convulsions. The intention of all these unconventional policies was to bring down interest rates and push the market into taking more risk. As a result, asset prices have soared and risk premiums have shrunk. Just look at this chart from Zero Hedge:

Now that the Fed is hinting that it is thinking about unwinding these programs, which Fed officials have quick to distinguish between taking the foot off the gas (tapering) and stepping on the brakes (tightening), risk premiums have begun to rise and asset prices have fallen. This chart from Gwyn Davies show that, despite Fed officials communications policy, the market has de facto tightened in spite of Federal Reserve actions:

Consider the effects of this reversal:

Treasury bond yields have spiked. The Fed's began with lowering short-term rates, progressed to buying Treasuries further out on the yield curve and finally added agencies to its purchases. Now that the Fed has signaled that it is considering winding down its QE program, Treasury yields have spiked.

It has caused carnage in the Eurodollar market. If you hold down short rates and then tell the world that you expect to hold short rates at zero or near zero for a long, long time, it is an invitation to Mr. Market to put on a carry trade - and it did, with leverage. The signal of reversal is causing these carry trades to unwind, the most obvious of which is the "get cheap funding and buy Eurodollar deposits" trade. See Vince Foster's Minyanville article Bernanke's Misfired Shot Heard 'Round the World.

Other carry trades like the currency carry trade are being unwound in a disorderly manner.

The Fed's implicit encouragement for the market to take risk pushed funds into junk and emerging market bonds. We have seen how investors reached for yield in the last few years, some of that money made its way into lower quality credits like junk bonds and emerging market bonds. In particular, the emerging market bond market has sold off in a frenzy. In addition, it has caused stress in a number of EM currencies as the market has begun to re-calibrate risk premiums.

The market's reach for yield likely played a role in China's latest shadow banking bubble and recent liquidity squeeze. Michael Pettis explained the carry trade this way:

Over the last two years, and especially in 2013, mainland corporations with offshore affiliates had been borrowing money abroad, faking trade invoices to import the money disguised as export revenues, and profitably relending it as Chinese yuan. As China receives more dollars from exports and foreign investment than it spends on imports and Chinese investment abroad, the People's Bank of China, the central bank, is forced to buy those excess dollars to maintain the value of the yuan. It does this by borrowing yuan in the domestic markets. But because its borrowing cost is greater than the return it receives when it invests those dollars in low-earning U.S. Treasury bonds, the central bank loses money as its reserves expand. Large companies bringing money into the mainland also force the central bank to expand the domestic money supply when it purchases the inflows, expanding the amount of credit in the system.

In May, however, the authorities began clamping down on the fake trade invoices, causing export revenues to decline. Foreign currency inflows into China dried up, as did the liquidity that had accommodated rapid credit growth. The combination of rapidly rising credit and slower growth in the money supply created enormous liquidity strains within the banking system. This is probably what caused last week's liquidity crunch and this week's market convulsions.

When Pettis wrote that Chinese companies imported foreign money and engaged in the practice of "profitably relending it as Chinese yuan", he is referring to injections into China's shadow banking system, which is really their subprime market. In a separate note, Izabella Kamanska of FT Alphaville also documented analysis from Deutsche's Bilal Hafeez indicating that the tight USD-CNY relationship was ripe for a carry trade.

Tapering talk has devastated the TIPS market. As the market has contemplated the reversal of QE, inflationary expectations have plummeted and so have the price of TIPS.

QE first buoyed commodity prices and now we are seeing the reversal of that trade. Gold and other hard commodities benefited from low and negative real interest rates. Now that we are seeing real interest rates rise (and inflationary expectations fall), commodity prices are getting hammered.

Tapering talk has also implicitly hurt Europe. The ECB has been able to stabilize the eurozone with Draghi's "whatever it takes" remark and the unveiling of its OMT program, which has not been activated yet. Yield spreads of peripheral countries' bonds against Bunds have narrowed because of the ECB's threat of action, along with the flood of global liquidity. Now that the flood of global liquidity is starting to recede, the ECB may actually have to resort to OMT, which would cause another round of euro-angst and more risk premium re-calibration.

I've probably forgotten or missed out on some other side effects of the various rounds of Fed QE, but you get the idea. Many of these bets were leveraged bets as they were designed to help banks profit and repair their balance sheets, e.g. the Eurodollar carry trade. When these trades unwind, the effects will not a blip, but a tsunami.

All these macro effects are suggesting that we are at the start of a risk re-pricing process that will take months to complete. It will not be friendly to asset prices at all.

Earnings headwinds
In the US, stock prices are starting to face headwinds from a deteriorating earnings outlook. Ed Yardeni documented that while Street earnings estimates continue to rise, forward sales estimates are falling. How long can this divergence continue? Can margins continue to rise?

One way of boosting earnings per share while the sales outlook is punk is to buy back shares. If you reduce the denominator (shares outstanding), earnings can rise (everything else being equal). Bloomberg reported that the level of share buybacks are so high that corporate quality is deteriorating [emphasis added]:

“The trend of improving credit quality has slowed as profits are slowing,” Ben Garber, an economist at Moody’s Analytics in New York, said in a telephone interview. “As the recovery matures, companies are liable to get more aggressive in taking on share buybacks and dividends.”

Rather than using cash to pay down debt, companies in the S+P 500 Index are attempting to boost their share prices by buying back almost $700 billion of stock this year, approaching the 2007 record of $731 billion, said Rob Leiphart, an analyst at equity researcher Birinyi Associates in Westport, Connecticut.

Borrowers controlled by buyout firms are on pace to raise more than $72.7 billion this year through dividends financed by bank loans, surpassing last year’s record of $48.8 billion, according to S+P Capital IQ Leveraged Commentary & Data.

After cutting expenses as much as they could to improve profitability, companies “will need to see further revenue growth to boost earnings from here,” Anthony Valeri, a market strategist in San Diego with LPL Financial Corp., which oversees $350 billion, said in a telephone interview.

The good news: Ursa Minor
All these factors add up to bad news for the stock market. The good news is that any pullback is likely to be relatively minor and the possibility of a market crash is remote. The Fed has made it clear that it continues to be "data sensitive" and will adjust policy as necessary.

Translation: The Bernanke Put still lives.

Relief rally: Mind the gap(s)
My inner investor has already pulled back to a position of defensiveness. My inner trader, on the other hand, is watching the relief rally for an entry point on the short side. I am indebted to Tim Knight for his idea of watching the charts of HYG, JNK and MUB to watch for rallies up to fill the downside gaps. The theory is that stocks often see trading gaps filled after a price reversal, just as we are seeing now. After that, the down trend would continue. Tim Knight put it more colorfully than I ever could:

There are three ETFs I am watching very closely for gap closes. My motivation is twofold: first, I want to short the everloving bejesus out of them once the gaps are filled, and second, it’s going to be my signal to go balls-out shorting the equities in general.

As I write these words, the gaps in HYG, JNK and MUB have been filled. However, my inner trader is not ready to short "the everloving bejesus" out of this market yet. He is more inclined to pivot from a pure US-centric view to a more global macro view of the world and he is watching how the gaps in the ETFs of some of the aforementioned sectors that were affected by the Fed's QE actions are resolving themselves.

Consider TLT, the long Treasury ETF, which has not rallied sufficiently to fill the (tinted) gap:

DBV, which is the ETF representing the currency carry trade, has seen its gap filled.

The emerging market ETFs have had their gaps either filled or mostly filled. Here is the chart for EM bonds (EMB):

Here is EM equities (EEM):

Here is China (FXI), which has been a focus of the markets in the past couple of weeks:

Commodity ETFs, however, aren't performing that well and they continue to be in a downtrend without rallying to fill their gaps. Here is DBC, as a representative of the entire commodity complex. DBC violated a key support level and continues to weaken. It has seen no rally attempt to fill in its gap.

Gold (GLD) is one of the ugliest charts of all. Note, however, how it rallied back in April and May to fill in the gap (shown in green) but it continues to weaken and has shown two gaps (in yellow) that have yet to been filled in a relief rally.

The currencies of commodity-linked economies are behaving badly. Here is the Aussie Dollar:

Here is the Canadian Dollar, which is continue to decline with an unfilled gap:

What about Europe? The chart of FEZ representing eurozone equities below shows that while we have seen a minor relief rally, eurozone equities have not rallied up to fill its gap.

Here's the score. Sectors with filled gaps: 3; unfilled gaps: 2. My inner trader's conclusion is that the relief rally isn't quite finished yet. We are likely to see several weeks of volatility before the process is complete before the longer term fundamentals of the recalibration of risk premiums pushes asset prices lower.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Saturday, June 29, 2013

I saw this article outlining the 5 qualities of great traders and I had to smile, especially when I got to point 5:

Loss cutting

Confidence

No ego

Consistency

Student of the markets

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Friday, June 28, 2013

Here is a thought for the weekend: Most people in business and particularly on Wall Street accept the principle that private enterprise does things better than government. A recent commentary about the Snowden Affair brings calls into question that assumption:

The story of Edward Snowden and how he got to be in a position where he could leak details of the National Security Administration’s (NSA) surveillance program is revealing a great deal about the privatization of our national security system. Much of what we are seeing is not pretty.

The critical question is, "How did so many private contractors wind up in the national security apparatus?"

However, apart from the extensive system of surveillance at the NSA, Snowden has also called attention to the extent to which national security operations have been privatized. Of course, Snowden did not work directly for the government; he worked for Booz Allen Hamilton, a private contractor. Booz Allen is a $6 billion a year business. It gets the vast majority of its revenue from government contracts like the one that paid Snowden’s salary.

While the specifics of Snowden’s work are not clear, we know that he was being paid more than $120,000 a year. That’s pretty good pay for someone who just turned 30 and never graduated high school. Needless to say, Booz Allen was billing the taxpayers even more for Snowden’s work since they are in business to make a profit. Snowden may have had extraordinary skills that would justify this sort of pay, but there is no way for the public to know.

It turns out that even the background check that provided the basis for Snowden’s security clearance was done by a private contractor. USIS, a company based in northern Virginia, did the background check on Snowden and many other people with security clearance.

Private contractors = Mercenaries
This reminds me of the commentary of Niccolò Machiavelli, who wrote The Prince. Contrary to popular belief, Machiavelli was not a prince, but an advisor in Florence during a tumultous period in Italy where the country was fragmented into small principalities and city-states and the region was in a constant state of conflict. Machiavelli fell out of favor and wrote The Prince as a way to try and regain favor but was ultimately unsuccessful. The Prince was known as being unusually frank about the practice of politics, which was contrary to Church doctrine of the time:

The descriptions within The Prince have the general theme of accepting that the aims of princes—such as glory and survival—can justify the use of immoral means to achieve those ends.

Machiavelli's work is applicable to modern times because the government's use of private contractors is effectively contracting out national security to a mercenary force. Here is what Machiavelli said about mercenaries [emphasis added]:

I say, therefore, that the arms with which a prince defends his state are either his own, or they are mercenaries, auxiliaries, or mixed. Mercenaries and auxiliaries are useless and dangerous; and if one holds his state based on these arms, he will stand neither firm nor safe; for they are disunited, ambitious and without discipline, unfaithful, valiant before friends, cowardly before enemies; they have neither the fear of God nor fidelity to men, and destruction is deferred only so long as the attack is; for in peace one is robbed by them, and in war by the enemy. The fact is, they have no other attraction or reason for keeping the field than a trifle of stipend, which is not sufficient to make them willing to die for you. They are ready enough to be your soldiers whilst you do not make war, but if war comes they take themselves off or run from the foe; which I should have little trouble to prove, for the ruin of Italy has been caused by nothing else than by resting all her hopes for many years on mercenaries, and although they formerly made some display and appeared valiant amongst themselves, yet when the foreigners came they showed what they were. Thus it was that Charles, King of France, was allowed to seize Italy with chalk in hand; 1 and he who told us that our sins were the cause of it told the truth, but they were not the sins he imagined, but those which I have related. And as they were the sins of princes, it is the princes who have also suffered the penalty.

I wish to demonstrate further the infelicity of these arms. The mercenary captains are either capable men or they are not; if they are, you cannot trust them, because they always aspire to their own greatness, either by oppressing you, who are their master, or others contrary to your intentions; but if the captain is not skilful, you are ruined in the usual way.

And if it be urged that whoever is armed will act in the same way, whether mercenary or not, I reply that when arms have to be resorted to, either by a prince or a republic, then the prince ought to go in person and perform the duty of captain; the republic has to send its citizens, and when one is sent who does not turn out satisfactorily, it ought to recall him, and when one is worthy, to hold him by the laws so that he does not leave the command. And experience has shown princes and republics, single-handed, making the greatest progress, and mercenaries doing nothing except damage; and it is more difficult to bring a republic, armed with its own arms, under the sway of one of its citizens than it is to bring one armed with foreign arms. Rome and Sparta stood for many ages armed and free. The Switzers are completely armed and quite free.

I conclude, therefore, that no principality is secure without having its own forces; on the contrary, it is entirely dependent on good fortune, not having the valour which in adversity would defend it. And it has always been the opinion and judgment of wise men that nothing can be so uncertain or unstable as fame or power not founded on its own strength. And one's own forces are those which are composed either of subjects, citizens, or dependants; all others are mercenaries or auxiliaries. And the way to take ready one's own forces will be easily found if the rules suggested by me shall be reflected upon, and if one will consider how Philip, the father of Alexander the Great, and many republics and princes have armed and organized themselves, to which rules I entirely commit myself.

In other words, the citizens of a democracy have obligations. Unless they are willing to bear the costs, they will bear the consequences of the use of a mercenary force, as Machiavelli predicted about 500 years ago. We have to bear in mind that, for certain functions, government does some things better than the private sector.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Wednesday, June 26, 2013

OK, so gold had a very ugly day. For some perspective, here is the long-term chart of gold stretching back to the start of the last gold bull:

This precious metal recently dropped through one important uptrend (dotted line). There is, however, one ultimate last line of defense for the gold bulls, which represents the uptrend stretching back to 2001 (solid line). Uptrend support appears to be at roughly $1150.

There are a number of hopeful signs for gold, at least in the short-term. Tim Knight at The Slope of Hope indicated that silver may be forming a bottom at these levels:

As well, Ed Yardeni showed that there is a high level of correlation between gold prices and TIPS:

Here is a short-term chart of GLD and TIP. TIP rallied today, though GLD sold off. This represents a short-term divergence, though minor, that cannot go on forever.

In short, precious metals appear to be setting up for a relief rally at these levels. However, keep an eye on the longer term trend to judge whether the gold bulls' last stand is successful or not.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Let's survey the technical damage that was done on Thursday and carried through to Friday. First and foremost, emerging market bonds continued to crater. Never mind the spread between EM bonds and Treasuries, look at the relative performance of EM bonds against US high yield, which broke an important relative support line.

The line in the sand for the 10-year Treasury yield was 2.4%, which was breached Thursday and decisively on Friday.

During this current stock market advance, European equities had halted bouts of weakness at the 200-day moving average. That support level was also broken.

On this side of the Atlantic, the 50-day moving average provided support for the SPX. The index went through the 50 dma convincing this week. However, my analysis of market internals indicate that the current weakness is likely to be just a minor correction. The most obvious support level from which this pullback ends is roughly the 1510 level, which represents the 200 dma and the uptrend line that stretches back to October 2011.

Bullish silver linings
There is no doubt that the equity bull trend experienced technical damage and a period of volatility and weakness is likely to follow. However, I believe that we will only experience a minor pullback for the following reasons:

The PBoC has dramatically tail risk on Friday with its liquidity injections;

Insiders are buying; and

Market internals remain bullish.

The PBoC dodges a bullet
Let's go through the points one at a time. On Friday, Bloomberg reported that the PBoC inject

China’s benchmark money-market rates retreated from records after the central bank was said to have made funds available to lenders amid a cash squeeze.

The one-day repurchase rate dropped 384 basis points, or 3.84 percentage points, to 7.90 percent as of 9:33 a.m. in Shanghai, according to a weighted average compiled by the National Interbank Funding Center. That is the biggest drop since 2007. The seven-day rate fell 351 basis points to 8.11 percent. They touched record highs yesterday of 13.91 percent and 12.45 percent, respectively.

I was highly concerned about tail risk because of the tight liquidity conditions in China, as it had the makings of a credit crunch. The PBoC was at risk of making a policy mistake, which could have evolved into a Lehman moment (as Zero Hedge is fond of pointing out). The act of liquidity injection alleviated many of those concerns.

Insiders are buying
Another intermediate term bullish factor is the emergence of insider buying. Mark Hulbert reported that corporate officers and directors have been leaning towards the buy side:

Based on his [finance academic Nejat Seyhun] analysis of how the stock market has tended to perform in the past whenever insiders were behaving like they are today, his best estimate is that the Wilshire 5000 index will rise 6.7% over the coming 12 months. Though that is lower than the stock market’s historical average return of around 10%, it would be a far better outcome than the decline that many on Wall Street worry will be the result of the Fed dialing back its stimulus program.

Past research has shown that insider buying is far more significant a signal than insider selling. Insiders may sell for all kinds of reasons. On the other hand, if an insider puts up his own hard earned cash to buy the shares of his own company, it's a far more significant indicator.

Positive market internals
In addition, market internals are not highly atypical of a severe downturn in the economy or rising systemic risk. For instance, I was concerned about the contagion risk posed by the EM sell-off. If market believes that contagion risk is rising, it should show up in the relative performance of financials. Consider the chart below of US financials against the market, which remains in a relative uptrend. In effect, Mr. Market is saying, "What financial contagion risk?"

Look at the relative performance of the Broker Dealers against the market. Broker Dealers represent the "high beta" portion of the financial sector. Not only is this group not selling off, it appears to have formed an head and shoulders pattern on a relative basis, which suggests further outperformance to come.

Take a look at the financials in Europe. While its near-term relative weakness may be reflective of anxieties over Greece, European financials remain range-bound against the broader market and Mr. Market is showing little sign of anxiety in this sector.

In the US, the economically sensitive sectors continue to perform well and display no signs of any severe concerns about an economic slowdown. The Morgan Stanley Cyclical Index remains in a long and well defined relative uptrend against the market.

Similarly, the Consumer Discretionary stocks are remain a relative uptrend.

I see a similar pattern in Europe. Here is the relative performance of the European Consumer Goods sector, which is in a choppy relative uptrend:

...and European Consumer Services, which staged an upside relative breakout in June:

Not out of the woods yet
These factors combine to paint a picture that the bears have a lot of work to do before taking control of the tape on an intermediate term basis. Unless the picture deteriorates, the current combination of insider buying and sector internals suggests to me that the stock market is due for a period of pullback and consolidation, but the outlook is no disaster.

However, stocks are not out of the woods in the near term. To put it simply, the market is oversold, but it's not severely oversold. The chart below shows the NYSE New highs - New Lows on the top panel and the SPX on the bottom panel. The NH-NL indicator is in oversold territory, but it hasn't reached the kinds of severe oversold readings that are consistent with the end of corrections.

CNN Money maintains a fear-greed index based on the combination of junk bond demand, market momentum, safe haven demand, put and call options, stock price strength and stock price breadth. As the chart below shows, readings are in fear territory, but they are not quite at severe extremes yet.

A correction and consolidation
To summarize, the PBoC's liquidity injection late last week signaled that tail risk in China has been drastically reduced. Nevertheless, we have seen considerable technical damage done to the equity bull. Markets remain jittery and every headline that comes across the tape about the timing of the Fed's QE taper will result in a risk-on or risk-off reaction.

However, insider activity and sector internals do not suggest that the global economy is turning down, which is bullish. Unless Street earnings expectations were to get revised down dramatically or the Chinese banking system liquidity flare up again, my base case is that the stock markets undergo a period of correction and consolidation. For the US averages, the likely floor under such a scenario is 1510 on the SPX.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest. None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Friday, June 21, 2013

I had a reader write me indicating that he found malware when he came to the site. Here is the screen shot:

Has anyone else had the same experience? If so, please contact me at cam at hbhinvestments dot com.and please include the platform (operating system, browser and virus software) that you are using.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest. None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Thursday, June 20, 2013

The fact that the Fed telegraphed its decision to begin tapering QE later this year, assuming that the current trajectory of economic data holds, was not an enormous surprise to me. However, the combination of the Fed decision, bad China data overnight and a liquidity squeeze in China have served to exacerbate the global market selloffs as I write these words.

Is this just a minor correction or the start of something worse? These are some technical lines in the sand that I am watching. First of all, the decline in the SPX has been contained at its 50-day moving average in the recent past. Can support at the 50 dma, which is at about 1618 hold?

As well, bond yields have been spiking in the wake of the FOMC decision. Past surges in 10-year Treasury yields have been contained at about the 2.4% level. Can 2.4% hold?

Bearish trigger in Europe
I have also been relatively constructive on European equities and believe it to be a value play. Despite the negative tone on the markets, eurozone PMIs have surprised on the upside (via Business Insider):

I wrote that past declines in European equities have been contained at its 200 day moving average (see The bear case for equities). Can the 200 dma hold?

Bearish trigger in emerging markets
In China, the combination of poor June flash PMI and a liquidity crunch have served to throw the markets into a tizzy. Zero Hedge reports that overnight repo rates spiked to 25%, which is evocative of the market seizures seen during the Lehman Crisis.

At this point, we don't know if this credit crunch is deliberate or if the Chinese authorities have lost control of the interbank market (see FT Alphaville discussion). Michael McDonough sounded the alarm about the possible negative effects of this credit crunch on Chinese growth:

Should the Chinese credit crunch get out of control and start to spill over into the global markets, we should see the first signs of it in emerging market bonds. I wrote to watch the relative performance ratio of the emerging market bond ETF (EMB) against US high yield (HYG), which is testing a key relative technical support level (see An EM yellow flag):

I had written in the past to watch the price of the Chinese banks listed in HK as warning signs (see The canaries in the Chinese coalmine). That indicator may have lost some of its power as Reuters reported on Monday that the Chinese authorities have stepped in to increase their stake the state banks in order to "boost confidence":

China's government has stepped up efforts to lift confidence in the country's flagging stock markets by buying more shares in the four biggest commercial banks, stock exchange statements showed on Monday.

This is the third time Huijin has been known to be buying shares in the secondary market since June 13, when China's stock market skidded to six-month lows after data showed the world's second-biggest economy was cooling faster than expected.

Watch the tripwires!
In summary, I wrote on Monday that my Trend Model had moved to "neutral" from "risk-on" (see Is the correction over?). For now, I am in watch and wait mode and monitoring these bearish tripwires before I go into full-flown "risk-off" mode:

Can the 50 dma hold for the SPX?

Can the 10-year Treasury yield breach the 2.4% level?

Can decline in the STOXX 600 be arrested at the 200 dma?

Will emerging market bonds melt down?

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest. None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Some $30 trillion in assets is expected to be shifted to younger generations over the next 30 years, according to Pershing LLC, a subsidiary of Bank of New York Mellon. And advisers typically lose half of the assets they manage when those assets are passed from one generation to the next, a 2011 study by consulting firm PriceWaterhouse Coopers found.

In a survey of 317 advisers conducted in February and March, Pershing found that more than half of their affluent clients had adult children, but advisers had talked about finances with only about a third of those children.

Advisers who don't want to lose those assets should get up to speed on how to win the next generation. The basics: Attract them with engaging events and modern practice-management methods, then retain them with solid financial planning.

The suggested solution is to spend time wooing the kids:

You can start by coordinating a family meeting so your clients can introduce you to their children. Make estate planning the focus so you can explore the family's expectations for their wealth - and try to ferret out situations where the parents and the children might have different financial objectives that could complicate your serving both of them at the same time.

Offer to provide complimentary financial planning to your clients' children. These accounts won't pay big, but the parents will appreciate it. Then hand off those accounts to younger advisers in your office. Not only will this be good practice for them, they'll probably be better at relating to the younger clients.

Focus more on the needs of Gen X and Millennials by "Remodeling for a hipper look":

Consider making over your office to make it more appealing to the next generation, said Wayne Badorf of Wells Fargo Asset Management, a practice-management expert. Put a few magazine-loaded iPads in the lobby, install Wifi and add energy drinks to your complimentary beverages.

You may need to revamp your online image. As long as your compliance officer approves, use your site to link to financial podcasts and interesting websites. And make it a portal for clients to access their statements and make updates to accounts.

Overly conventional thinking
I believe that such approaches are likely to yield disappointing results. When I speak to affluent Baby Boomers, their fears are that their children will not have the tools to properly manage their wealth. Their darkest fear is their kids acquire the Paris Hilton syndrome. A common refrain is, "What happens when my twentysomething son/daughter gets this [six or seven figure] windfall drop in their laps?"

Studies reviewed by the Library of Congress indicate that U.S. retail investors lack basic financial literacy. The studies demonstrate that investors have a weak grasp of elementary financial concepts and lack critical knowledge of ways to avoid investment fraud.

A 2009 FINRA study found that investors way over-estimated their own financial knowledge. They were fairly confident about their own abilities, but when asked some basic financial concepts, their understanding was appalling lacking. Here are the questions, which shouldn't be that difficult for anyone who has some basic financial understanding:

Imagine that the interest rate on your savings account was 1% a year and inflation was 2% a year. After one year, how much would be able to buy with the money in this account? [More|Less] (64% correct)

If interest rates rise, what will typically happen to bond prices? (21% correct)

Supposing that you had $100 in a savings account and the interest rate was 2% per year. After five years, how much do you think you would have in the account if you left the money to grow? [More than $102|Less than $102] (65% correct)

A 15-year mortgage typically requires higher monthly payments than a 30-year mortgage, but the total interest paid over the life of the loan will be less. [True|False] (70% correct)

Buying a single company's stock usually provides a safer return than a stock mutual fund. [True|False] (52% correct)

Financial literacy + Instilling passion = Value creation
There is a silver lining in this dark cloud. The FINRA study showed that higher income groups were more financially literate than the general population. Nevertheless, I believe that the road to recruiting the next generation of clients is involves a dual-track approach of financial education and instilling a passion for creating wealth. The latter is important because it shifts the attitude of the next generation from viewing the inheritance as consumption (the Paris Hilton symdrome) to wealth generation.

Katherine Lintz of Financial Management Partners seems to have hit the right notes in her approach, according to this Bloomberg report:

They call it “money camp.” Twice a week, 6- to 11-year-old scions of wealthy families take classes on being rich. They compete to corner commodities markets in Pit, the raucous Parker Brothers card game, and take part in a workshop called “business in a box,” examining products that aren’t obvious gold mines, such as the packaging on Apple Inc.’s iPhone rather than the phone itself.

The results have been astounding:

Lintz, 58, is on to something. Her 22-year-old firm was No. 2 among the fastest-growing multifamily offices in the second annual Bloomberg Markets ranking of companies that manage affairs for dynastic clans, Bloomberg Markets magazine reports in its September issue. The assets that FMP supervises grew 30 percent to $2.6 billion as of Dec. 31, just behind Signature, a Norfolk, Virginia-based family office that expanded 36 percent in 2011 to $3.6 billion.

I believe that Lintz has found a formula that many financial advisory firms catering to the HNW market has ignored or didn't know how to approach - the issue of how to recruit the next generation of clients. By combining financial literacy education and an approach that instills a passion for creating wealth, her firm has made its AUM much stickier and fashioned an important tool to recruit older clients who are concerned about these issues of how to pass the family torch.

Investment firms, analysts and advisors spend a lot of time talking and thinking about how companies create value. This is one way of how investment firms can create values for themselves.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest. None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Tuesday, June 18, 2013

I wrote last week that I was closely watching the behavior of emerging market bonds to see if we are experiencing just a minor market correction or if this is the start of something worse (see The bear case for equities). EM bonds had stabilized late last week and my inner bull breathed a sigh of relief. Then today(Tuesday), which was a risk-on day for global equity markets, EM bonds took a nasty tumble and set off alarm bells again.

Consider this chart of the relative performance of EMB (emerging market bonds ETF) against HYG (US high yield ETF). EMB successfully tested a key relative support level and rallied. Just as I started to get constructive on the risk-on trade, EMB reversed itself and went south again.

Here is a close-up look of the same chart with a one-year history:

Unlike emerging market bonds, emerging market equities never bounced. Here is the chart of the relative performance of EM equities (EEM) against the MSCI All-Country World Index (ACWI):

What was unsettling was that this EM selloff occurred on a global equity risk-on day when the Dow Jones Industrials was up over 100 points. While the selloff is not terribly surprising as we saw hot money rush into EM as the Fed and other global central banks engaged in repeated rounds of quantitative easing. Most recently, SocGen analyst Kit Juckes wrote that we are seeing the down slope of an emerging markets bubble.

The most likely priximate source of the Tuesday's EM weakness was a reaction to the spike in the Shanghai Inter-bank Offered Rate (SHIBOR), which was an indication of tightening credit conditions in China:

David Keohane of FT Alphaville has an excellent discussion of the Chinese credit conditions and an assessment of the risks here. Walter Kurtz of Sober Look also pointed out that the SHIBOR curve is highly inverted and inverted yield curves are indications of tightening credit conditions and can be precursors to economic slowdowns and recessions.

At this point, the EMB/HYG ratio has not convincingly fallen through relative support. I regard this as a yellow flag and not a red flag. Nevertheless, these readings are indicative of how jittery the markets are.

All eyes are on the Fed. If the FOMC statement is not satisfactory to the markets and the markets sell off, it wouldn't take much to turn the yellow flag into a red flag.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest. None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Monday, June 17, 2013

The recent bout of volatility in the capital markets owes much to the turmoil seen in the emerging markets. Both emerging market bonds and equities have recently been hammered on the basis of:

Slower growth in China; and

The whispers of Fed "tapering", which caused an unwind of the risk trade in EM bond and equities.

By the end of the week, it appeared that the storm that was battering the markets was abating. Breadth indicators had reached oversold levels and fear levels were starting to recede. Consider this chart of the NYSE New highs - New lows, which fell to levels consistent with the end of past minor corrections and saw a bounce late in the week.

Bill Luby at VIX and More suggested watching DBV, the currency carry trade ETF, as a measure of risk appetite. Look at the five year weekly chart, DBV fell to the bottom of its Bollinger Band, which is an indication of an oversold condition, and mean reverted late in the week. Such mean reversion rallies from oversold are classic buy signals.

The question then becomes one of whether this is just a minor correction of the start of a bigger bearish impulse in stock prices. As I mentioned earlier, the fear of Fed tapering threw a scare into emerging markets, largely because the QE promise of cheap money pushed a lot of "hot money" into EM and the prospect of an unwinding caused the "hot money" to rush for the exits.

The carnage is particularly acute in emerging market equities. The chart below shows the relative performance of emerging market stocks (EEM) to the MSCI All-Country World Index (ACWI). This longer term chart back to 2008 looks rather ugly. EM equities staged a relative rally in the wake of the Lehman Crisis but topped out in 2010 and they have been underperforming global equities ever since. Earlier this year, EEM broken an important relative support level against ACWI and has been plunging ever since. From a technical viewpoint, there is no bottom in sight.

Emerging market bonds, however, tell a different story. I wrote last week that I was worried about the signal from the EM bond market and to watch the relative performance of EM bonds relative to US high yield market for signs of a break (see The bear case for equities). Lo and behold, EM bond prices recovered strongly late in the week, not only against US high yield, but against 7-10 year Treasuries:

At a crossroads: The Fed, China and earnings
Which is giving us a better signal? EM bonds or equities?

My trader's instincts tell me that, in all likelihood, that the correction is over. The market saw oversold conditions on a number of indicators and the VIX Index hit levels that saw the end of past corrections. The key "tell" were the reversals in these short-term indicators

On the other hand, nagging doubts remain as the sources of volatility are still intact. First and foremost, the prospects of Fed tapering has heightened market volatility? Tim Duy believes that the September FOMC meeting is the most likely point at which the Fed announces that it would start to pull back on QE and his view is becoming the consensus one. He pointed to the likely trajectory of the unemployment rate as one of the key triggers of when the Fed would start to pull back.

On the other hand, Benn Steil and Dinah Walker indicated how difficult it is for the Fed to project unemployment rates by showing how the forecasts have changed over time and the likely effects on the timing of a change in policy.

Moreover, another debt ceiling fight is looming in September. The Hill reports:

A drawn-out debt ceiling fight in Congress could undermine the jobs growth that is expected later this year.

Economists argue that the nation's economic expansion is poised to accelerate in the fall once it weathers the headwinds of tax hikes and spending cuts.

While I recognize that any Fed action is highly "data dependent", would the FOMC move in the face of such fiscal uncertainties?

In all likelihood, Fed will probably calm market expectations about "tapering" in their FOMC statement on Wednesday, as signaled by the Jon Hilsenrath article. Nevertheless, sources of volatility remain as the markets are still highly jittery. Bloomberg reports that regardless of what the Fed has or hasn't done, it has managed expectations to such an extent that it has de facto tightened. Just look at the expectations for Fed Funds rates:

China and the EM contagion effect
In addition, the markets will stay jittery as signs of softness in China emerge, which they have as shown by Ed Yardeni's analysis:

The signals from commodity markets, a key indirect forward looking indicator of Chinese growth, have been mixed. While some key commodities like crude oil have seen prices stabilize and possibly stage upside breakouts...

On the whole, the entire commodity complex remains weak and the downtrend in prices remain intact.

The latest bout of turmoil in emerging market bonds and equities represent a cautionary tale for investors. If the mere whiff of Fed tapering of its QE program is throwing the EM capital markets into a tizzy, what happens if China hard lands if it is unable to successfully navigate its transition from a capital intensive economy to a consumer based economy? The World Bank recently issued a warning on the risks to the Chinese economy (via the BBC):

"The main risk related to China remains the possibility that high investment rates prove unsustainable, provoking a disorderly unwinding and sharp economic slowdown," it warned.

It further added that "should investments prove unprofitable, the servicing of existing loans could become problematic - potentially sparking a sharp uptick in non-performing loans that could require state intervention".

The agency said the scale of credit was so extreme that the country would find it very hard to grow its way out of the excesses as in past episodes, implying tougher times ahead.

"The credit-driven growth model is clearly falling apart. This could feed into a massive over-capacity problem, and potentially into a Japanese-style deflation," said Charlene Chu, the agency's senior director in Beijing.

"There is no transparency in the shadow banking system, and systemic risk is rising. We have no idea who the borrowers are, who the lenders are, and what the quality of assets is, and this undermines signalling," she told The Daily Telegraph.

If China were to slow dramatically, what about the contagion effect? While many global banks can claim that they have little or no direct exposure to China and its shadow banking system, which is a likely source of downside volatility, can the same banks say that they won't be exposed if a Chinese slowdown affects the risk premiums in EM bond and equities? Would these same global banks have the same level of minimal exposure to other EM markets like Poland, Turkey, India, Brazil, Malaysia and Indonesia (just to name a few?)

Sam Ro at Business Insider highlighted a Morgan Stanley research report that showed the history of past EM crises:

He went out to show the effects of the contagion effect on these markets [my emphasis]:

"Most shocks that have created sudden stops in the last 30 years have not been big enough to engulf all of EM, nor did they affect systematically important countries first," write the analysts. "Rather, it was the combination of a shock to a vulnerable economy and contagion that spread the shock to other economies sharing a common characteristic with the economy at the epicenter of the shock."

What about earnings?
As well, the outlook for US equity earnings estimates is a source of uncertainty. Ed Yardeni recently showed that Street estimates for revenues have ticked down, which is bearish:

On the other hand, earnings estimates continue to rise:

Can this be right? The top line estimates are falling but the bottom line estimates are rising? Margins would have to improve. By contrast to Yardeni's analysis, Thomson-Reuters showed that Q2 earnings guidance is the most negative on record:

Most of the negative guidance has been concentrated in the Healthcard, Consumer Discretionary and Technology sectors. We can interpret these readings in one of two ways. The most obvious is, "Wow! Earnings are going to be ugly and stocks are going to get hammered." The more nuanced take is that companies are guiding down expectations so that they can beat Street estimates, so most of the bad news is out already.

I have no idea which is the correct way of interpreting the deluge of negative guidance. Add in the uncertainty of the effects of sequestration, the wobbles last week in consumer confidence offset by the positive surprise in retail sales, you have the ingredients for more uncertainty and volatility.

Correction over?
Is the correction over? I honestly don't know. Last Monday, my Trend Model moved from a "risk-on" reading to "neutral", but my level of confidence in its forecast has fallen because macro uncertainty has risen substantially. We are at a crossroads in terms of market direction. My best forecast is that volatility is likely to continue.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest. None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

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Welcome to my blog Humble Student of the Markets. These are my observations and musings about the markets (mostly equities), hedge funds and investments in general.My experience has been a quantitative equity manager in US, Canada, EAFE and Emerging Markets and commentator on hedge funds and their returns patterns.

DISCLAIMERThis is not investment advice! I know nothing about you, your risk preferences, your portfolio or your investment horizon. I have no idea whether any of my opinions expressed are suitable for you.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. I may hold or control long or short positions in the securities or instruments mentioned.